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Target Date: Now

The future is very bright for the already popular lifecycle funds

A few years ago, you'd be hard-pressed to hear the term "lifecycle" or "target date" funds being bandied about the financial services arena. Today, however, target date funds are on the tips of everyone's tongues, particularly since the Department of Labor (DOL) recently issued its final rules designating these funds as one of its three Qualified Default Investment Alternatives (QDIAs) suitable for retirement accounts.

Target date funds have become popular because they offer participants in 401(k)s a "set it and forget it" investing option to help save for retirement. Most participants would rather delegate the chore of divvying up their retirement account among the appropriate investments, and target date funds do just that by investing in funds that are more aggressive or equity-heavy early on, and then become more conservative as the worker nears retirement.

Now that target date funds have been selected as a QDIA, industry observers predict the number of target date funds will mushroom. As it stands now, total assets in these funds were at $167.8 billion as of September 30, 2007, according to Financial Research Corp. (FRC) in Boston. Some estimate that as many as 40% of all 401(k) plans have or will be offering target date funds as an investment option in the near term, writes Paul Kampner, president of TMark Associates in Chicago, in a recent research paper, "Target Date Funds in 401(k) Plans." Lipper estimates that total net assets in lifecycle funds have grown at a 60% to 70% clip each year since 2002, with 2007 likely to see 60%-plus net asset growth over year-end 2006.

There are now 246 target date funds available from 36 fund families, FRC says, with Fidelity, Vanguard, and T. Rowe Price holding the lion's share (79%) of the total assets in these funds. Fidelity Distributors, the brokerage firm's retail arm, holds 46.6% of the assets in lifecycle funds; Vanguard is next with 16.5% of the assets; and T. Rowe Price comes in third with 16.12% of the assets, according to FRC. Fidelity's advisor-sold funds, meanwhile, holds 3.6% of the assets--$6.1 billion, FRC says. (See sidebar for a list of when fund families launched their lifecycle fund offerings.)

Target date funds have been near saviors for the moribund mutual fund industry. Lipper analyst Tom Roseen noted in Lipper's September FundIndustry Insight Report, that over the "last year-plus period, investors in no-load distribution channels continue to prefer the one-stop investment target horizon funds," noting also that "year-over-year flows into lifecycle funds have increased significantly and have rivaled those of World Equity Funds." What's more, Roseen said, "without positive inflows into target date funds, the flows of domestic equity funds as a group would have been in negative territory for three or four months of 2007." Andrew Clark, head of research for Lipper in Denver, adds that "target date funds have been a consistently strong source of inflows in an industry that has seen declining-to-negative flows into its other domestic offerings since mid- to late-2003."

Advisors' Influence

Industry experts predict that investment advisors will continue to boost lifecycle funds' popularity. While DOL crowned target date funds, managed accounts, and balanced funds as the three QDIAs of choice, Matt Smith, managing director of Russell Retirement Services, opines that target date funds will be "the most used." Using lifecycle funds is "a very good way to manage an asset allocation over time where the participant doesn't have to intervene, and it's sensible, particularly given that we know that as people get closer to retirement, their exposure to investment risk is magnified by the fact that their account balance is going to be at its maximum," Smith says. "Therefore, target date funds, all of them, manage that risk downwards as you get to retirement." Ron Surz, president and CEO of PPCA Inc. in San Clemente, California, says that managed accounts actually "hold the most promise for advisors," but working with these accounts "requires adherence to an audited prudent investment process, such as that being created by fiduciary advisors." This process, Surz argues, "could take years to achieve scale." Therefore, he says, "target date funds are the immediate play."

But the challenge for advisors and employers that sponsor retirement plans is deciding which target date funds to choose; this is exacerbated by the fact that historical data is hard to come by. Also, notes Clark of Lipper, buying a target date fund is more complex than buying a single mutual fund because "a typical target date fund can invest in anywhere from five to 20 underlying funds at any one time." Understanding a lifecycle fund's glide path--the asset allocation scheme the fund is using--is tasking too, because the "glide path varies among the funds that are out there," says Smith of Russell. Indeed, Clark writes in his Lipper report that even if a fund has the same target date, say 2030, the glide paths "can vary radically." The differing glide paths "make assessing performance on either a historical or forward-looking basis difficult," Clark says. "Varying asset allocation schemes mean varying expense levels, so the expense 'sleeves' can be difficult to assess across target-date funds as well."

Smith with Russell adds that plan sponsors and advisors still have a fiduciary duty in regards to QDIAs. "Even when a plan sponsor chooses an investment in one of the approved QDIAs, they still have to do the due diligence on that specific fund that they chose and monitor it on an ongoing basis."

Indeed, because there are "no good yardsticks for gauging performance" of target date funds, says Surz of PPCA, he recently co-founded Target Date Analytics (TDA) (www.tdbench.com), which helps advisors, plan sponsors, and participants "identify best practices in target date funds, and create indexes that adhere to these practices." Surz notes that the three indexes are "not just hypothetical; they are totally investable. Everyone can actually hold the TDA indexes." The other two founders of TDA are Craig Israelsen, a family and personal finance professor at Brigham Young University, and Joe Nagengast, president of Turnstone Advisory Group. "There's a real gap in indexes for target date funds," says Israelsen. "There are thousands of indexes--S&P, Lipper, Morningstar--and then you get to target funds, which will mushroom [in number], and to date, we only have the one Dow Jones Target Date Indexes," which includes just one 20/20 index, he says. "We felt there was an opportunity to build a different set of indexes with three risk levels [conservative, moderate, and aggressive] per target date. We're hoping these become the default benchmark for target date funds."

In Search of Best Practices

As for best practices among target date funds, Surz says too many are leaving their funds "in a substantial risky asset allocation at target date." The motivation for higher risky balances at target date, Surz writes in a recent paper, is that the "'current' fund morphs into a distribution fund. But this is not in the best interests of the investor. All sorts of distribution alternatives are springing up to accommodate a diverse set of objectives and circumstances in retirement." He continues: "These distribution choices are much more complicated than the accumulation decisions, so target date funds should stick to just the single objective of accumulation."

While there's been talk that target date funds have high fees, Israelsen says they're actually "not terrifically expensive." Vanguard's target date funds, as one might expect, have the lowest expense ratios at around 20 basis points; that compares to the 70-basis-point average expense ratio for all the current lifecycle funds that are available, he says. When looking at the universe of funds with target dates of 2010, 2015, 2020, and so forth, the expense ratio gets higher because the fund is more "equity heavy as you get further out in the target date," Israelsen says.

The Auto Factor

Another area that's sure to boost target date funds' use is the fact that employers continue to automate their 401(k) plans--mainly in three ways, auto enrollment, auto escalation, and auto investing. A recent survey by Hewitt Associates found that one-third, or 37%, of companies automatically enrolled their employees in their 401(k) plans in 2007, up from just 19% in 2005. Of those companies, more than 77% defaulted employees into a diversified portfolio, the survey revealed, such as a "target-risk, target-maturity, or balanced fund." Only 39% used one of these approaches in 2005. Hewitt's survey also found that 83% of companies set their default contribution rates at 3% or higher, compared to just 66% two years ago. Then there's automatic investing for participants, "in which target date [funds] are becoming the automatic default," says Smith with Russell.